Ratio analysis helps in analyzing the financial statements of any firm namely; the balance sheet and profit and loss account.
In fact the credit analysts who are employed by the bankers and financial institutions are making use of the financial ratios for the purpose of comparing the risk and return of a firm.
Categories of ratios:
There are five broad ratio categories which are in use for the purpose of measuring the different aspects of risk and return relationships.
They are activity analysis; liquidity analysis; solvency analysis; profitability analysis and performance analysis.
The credit analyst’s primary focus should be the relationships indicated by the ratio and in case ratio needs to be disaggregated, it should be done by taking the different variables which are relevant to either of the basic indicators in the ratio.
The following ratios are called as liquidity ratios namely; current ratio and quick ratio or acid test ratio.
It is the ratio between the current assets and current liabilities of any firm. Current assets comprise the following namely; cash balance, bank balance, sundry debtors, inventory, advance paid to the suppliers etc. Similarly, current liabilities consist of overdraft availed from the banks, sundry creditors, provisions for tax and others, advance payment received from the customers etc.
The formula for arriving current ratio is current assets/current liabilities.
This ratio offers an approximate measure of the company’s ability to pay its current maturing obligations on time. Generally, higher the current ratio, the greater the cushion a company has to work within meeting its current obligations. It is normally believed that a current ratio of 2 to 1(current assets:2 and current liabilities:1) is viewed as a sign that a company had done well. However, it is at present recognized that other factors such as the composition and quality of assets should be considered.
A current ratio of 4 to 1 cannot be acceptable if much of the company’s current assets comprise of inventory that is slow moving or obsolete. Alternatively, current ratio below the benchmark may be satisfactory for a company holding a high percentage of its current assets in cash, securities and non delinquent accounts receivable.
Current ratio measures the short term solvency of the company, shows the liquidity position of the enterprise or its ability to meet the current obligations. Even though higher ratio is considered to be good from the point of view of the creditors, in the long run, very high current ratio is found to affect the profitability of the firm to a large extent.
The current ratio does not provide the credit analyst the quality of the assets or the timing of the liabilities. From the current ratio, the period by which the sundry debtors are expected to be realized; or the sundry creditors are expected to be paid etc., cannot be calculated. It merely provides the comparative analysis between the current assets and current liabilities.
There is no definite bench mark for current ratio and it depends upon the perception of the credit analysts. Normally it is believed that the current ratio of 1.33: 1 is considered to be good for some borrowers and in certain cases, the current ratio of 1.25: 1 is also accepted.